1Foreign Exchange Risk:into

When companies conduct business across borders, they must deal in foreign currencies . Companies must exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables. This is done at the current exchange rate between the two countries. Foreign exchange risk is the risk that the exchange rate will change unfavorably before the currency is exchanged.

definition
The risk that the exchange rate on a foreign currency will move against the position held by an investor such that the value of the investment is reduced. For example, if an investor residing in the United States purchases a bond denominated in Japanese yen, a deterioration in the rate at which the yen exchanges for dollars will reduce the investor's rate of return, since he or she must eventually exchange the yen for dollars. Also called exchange rate risk.

meaning Foreign exchange is essential to coordinate international business transactions. Foreign exchange describes the process of trading different currencies to make and receive payments. Additionally, investors look to foreign exchange markets to trade currencies for a profit. These foreign exchange transactions do carry distinct risks. In order to minimize risks, you should understand the factors related to currency fluctuations, before coordinating business strategy.

Identification
1. Foreign exchange rates track the economic and political standing of a particular nation. Countries with stable political legislation and strong economies support higher currency values. Conversely, weak exchange rates for a country may signal economic recession and political instability. For example, institutions are less likely to do business within countries that are engaged in regional warfare.

Features
2. Foreign exchange risks relate to currency movements that adversely affect your bottom line. For example, American businesses holding Japanese yen reserves lose purchasing power when the yen declines. Alternatively, Japanese exporters suffer when the yen appreciates. At that point, Japanese exports become more expensive for overseas buyers.

Considerations
3. Foreign exchange markets introduce political risks. In recession, citizens highlight unfavorable exchange rates as evidence that politicians are mismanaging the economy . Unfavorable exchange rates generally translate into either foreign trade deficits or inflation for the domestic economy. High exchange rates slow the export economy, while low exchange rates increase the costs for imported goods. Politicians may respond to these conditions

with reforms, such as import quotas and duties, which are designed to protect the domestic economy.

Strategy
4. Diversified business portfolios and currency derivatives manage foreign exchange risks. Diversification allows you to profit amidst numerous economic scenarios. For example, high oil prices may translate into a strong economy and ruble in resource-rich Russia, while the U.S. falls into recession and the dollar declines. Larger American companies may set up operations in Russia to diversify themselves against the American slowdown. Individual investors, however, may purchase mutual funds that target Russian investments. Beyond diversification, sophisticated investors use currency derivatives, such as futures, options, and forwards to minimize foreign exchange risks. Currency derivatives work to lock in predetermined exchange rates for set periods. Futures and options are currency derivatives that trade on organized exchanges, such as the Chicago Mercantile Exchange. Options grant you the choice of accepting a set exchange rate, while futures contracts require settlement at predetermined currency rates. Alternatively, forwards are customized agreements between two parties that establish exchange rates to trade currencies between themselves at a later date.

Warning
5. International business associated with foreign exchange markets translates into contagion risks. Contagion is when economic distress spreads from one country and throughout regions to affect the global marketplace. For example, Mexican government default on its official debt would cause the Mexican peso to collapse. At that point, foreign investors doing business in Mexico would suffer substantial losses. These investors would then sell off their domestic investments for cash, which would lead to stock market declines in their respective home countries.

2 nature of foreign exchange risks

Foreign Exchange dealing is a business that one get involved in, primarily to obtain protection against adverse rate movements on their core international business. Foreign Exchange dealing is essentially a risk-reward business where profit potential is substantial but it is extremely risky too. Foreign exchange business has the certain peculiarities that make it a very risky business. These would include:
Forex deals are across country borders and therefore, often foreign currency prices are subject to controls and restrictions imposed by foreign authorities. Needless to say, these controls and restrictions are invariably dictated by their own domestic factors and economy. Forex deals involve two currencies and therefore, rates are influenced by domestic as well as international factors.

The Forex market is a 24-hour global market and overseas developments can affect rates significantly. The Forex market has great depth and numerous players shifting vast sums of money. Forex rates therefore, can move considerably, especially when speculation against a currency rises. Forex markets are characterized by advanced technology, communications and speed. Decision-making has to be instantaneous.

3 foreign exchange risk factors

While the FOREX (Foreign Exchange Market) is an incredibly lucrative venture for many investors, it is also a risky market that requires some knowledge and skill to navigate. Without the proper foreknowledge, it is possible to lose everything in a single bad venture, or to lose money over time through a series of poor investments. Knowledge is built up over time, and learning how to assess the risks associated with the FOREX can make the difference between losing and earning money.

Scams
Scams are one of the easiest ways to lose money on the foreign exchange. While it might seem appealing to go with the first choice when it comes to picking a broker to use on the FOREX, it is always worthwhile to do research on that company before you invest even a single penny. The most reputable companies will always be associated with large banks or financial institutions , as well as associated with the proper authorities and government agencies. All United States brokers will be registered with either the CFTC (Commodities Futures Trading Commission) or the NFA (National Futures Association).

Exchange Rates
No one can predict the fluctuations of exchange rates around the world with complete accuracy. There are always variables that individuals, as well as companies do not see. Even if an algorithm is used to attempt and predict how the market will swing in a particular direction, prices can often rise or drop far swifter than anticipated. Stop loss measures can help avoid taking too large of a hit on an unexpected exchange rate swing, but it is still a risk that can affect any trader or broker.

Credit Risks
There is always a risk that one of the parties involved in a foreign exchange transaction could fail to hold up their end of the bargain. This could be due to a lack of funds, bankruptcy, or such as when a bank declares insolvency. It is vitally important to work with organizations that have their credit worthiness regularly

monitored in order to keep your credit risk at a minimum; otherwise, you could be left holding the short end of the stick, not to mention empty pockets.

Exposure Risks
The FOREX is largely about exposure. The more money you have on the market, the more money you stand to gain...or lose. The greater the exposure, the greater the risk, but it is also true that the greater rewards can only be gained by being willing to risk larger sums. Still, given the risky nature of foreign exchange ventures as a whole, it is always wise to limit your exposure unless you are willing to accept the risks associated with putting a large bankroll on the line.

4 Description of Foreign Exchange Risk

In simple word FOREX risk is the variability in the profit due to change in foreign exchange rate. Suppose the company is exporting goods to foreign company then it gets the payment after month or so then change in exchange rate may effect in the inflows of the fund. If rupee value depreciated he may loose some money. Similarly if rupees value appreciated against foreign currency then it may gain more rupees. Hence there is risk involved in it.

5 Classification of Foreign Exchange Risk

Position Risk Gap or Maturity or Mismatch Risk Translation Risk Operational Risk Settlement or Credit Risk

1. Position Risk The exchange risk on the net open Forex position is called the position risk. The position can be a long/overbought position or it could be a short/oversold position. The excess of foreign currency assets over liabilities is called a net long position whereas the excess of foreign currency liabilities over assets is called a net short position. Since all purchases and sales are at a rate, the net position too is at a net/average rate. Any adverse movement in market rates would result in a loss on the net currency position. For example, where a net long position is in a currency whose value is depreciating, the conversion of the currency will result in a lower amount of the corresponding currency resulting in a loss, whereas a net long position in an appreciating currency would result in a profit. Given the volatility in Forex markets and external factors that affect FX rates, it is prudent to have controls and limits that can minimize losses and ensure a reasonable profit. The most popular controls/limits on open position risks are:
Daylight Limit : Refers to the maximum net open position that can be built up a trader during the course of the working day. This limit is set currencywise and the overall position of all currencies as well. Overnight Limit : Refers to the net open position that a trader can leave overnight to be carried forward for the next working day. This limit too is set

currency-wise and the overall overnight limit for all currencies. Generally, overnight limits are about 15% of the daylight limits.

2. Mismatch Risk/Gap Risk Where a foreign currency is bought and sold for different value dates, it creates no net position i.e. there is no FX risk. But due to the different value dates involved there is a mismatch i.e. the purchase/sale dates do not match. These mismatches, or gaps as they are often called, result in an uneven cash flow. If the forward rates move adversely, such mismatches would result in losses. Mismatches expose one to risks of exchange losses that arise out of adverse movement in the forward points and therefore, controls need to be initiated. The limits on Gap risks are:
Individual Gap Limit : This determines the maximum mismatch for any calendar month; currency-wise. Aggregate Gap Limit : Is the limit fixed for all gaps, for a currency, irrespective of their being long or short. This is worked out by adding the absolute values of all overbought and all oversold positions for the various months, i.e. the total of the individual gaps, ignoring the signs. This limit, too, is fixed currency-wise. Total Aggregate Gap Limit : Is the limit fixed for all aggregate gap limits in all currencies.

3. Translation Risk Translation risk refers to the risk of adverse rate movement on foreign currency assets and liabilities funded out of domestic currency. There cannot be a limit on translation risk but it can be managed by:
1. Funding of Foreign Currency Assets/Liabilities through money markets i.e. borrowing or lending of foreign currencies 2. Funding through FX swaps 3. Hedging the risk by means of Currency Options 4. Funding through Multi Currency Interest Race Swaps

4. Operational Risk The operational risks refer to risks associated with systems, procedures, frauds and human errors. It is necessary to recognize these risks and put adequate controls in place, in advance. It is important to remember that in most of these cases corrective action needs to be taken post-event too. The following areas need to be addressed and controls need to be initiated.
Segregation of trading and accounting functions : The execution of deals is a function quite distinct from the dealing function. The two have to be kept separate to ensure a proper check on trading activities, to ensure all deals are accounted for, that no positions are hidden and no delay occurs. Follow-up and Confirmation: Quite often deals are transacted over the phone directly or through brokers. Every oral deal has to be followed up immediately by written confirmations; both by the dealing departments and by back-office or support staff. This would ensure that errors are detected and rectified immediately.

Settlement of funds: Timely settlement of funds is necessary not only to avoid delayed payment interest penalty but also to avoid embarrassment and loss of credibility. Overdue contracts: Care should be taken to monitor outstanding contracts and to ensure proper settlements. This will avoid unnecessary swap costs, excessive credit balances and overdrawn Nostro accounts. Float transactions: Often retail departments and other areas are authorised to create exposures. Proper measures should be taken to make sure that such departments and areas inform the authorised persons/departments of these exposures, in time. A proper system of maximum amount trading authorities should be installed. Any amount in excess of such maximum should be transacted only after proper approvals and rate.

5. Credit Risk Credit risk refers to risks dealing with counter parties. The credit is contingent upon the performance of its part of the contract by the counter party. The risk is not only due to non performance but also at times, the inability to perform by the counter party. The credit risk can be
Contract risk: Where the counter party fails prior to the value date. In such a case, the Forex deal would have to be replaced in the market, to liquidate the Forex exposure. If there has been an adverse rate movement, this would result in an exchange loss. A contract limit is set counter party-wise to manage this risk. Clean risk: Where the counter party fails on the value date i.e. it fails to deliver the currency, while you have already paid up. Here the risk is of the capital amount and the loss can be substantial. Fixing a daily settlement limit as well as a total outstanding limit, counter party-wise, can control such a risk. Sovereign Risk: refers to risks associated with dealing into another country. These risks would be an account of exchange control regulations, political instability etc. Country limits are set to counter this risk.

6 Foreign exchange risks management by banks:When the foreign currency denominated assets and liabilities are held, by the banks or the business concern, two types of risks are faced. Firstly, the risk that the exchange rates may vary and the change may affect the cash flows/profits. This is known as exchange risk. Secondly, the interest rate may vary and it may affect the cost of holding the foreign currency assets and liabilities. This is known as interest rate risk. The present section discusses exchange risk management by banks. Dealing Position Foreign exchange is such a sensitive commodity and subject to wide fluctuations in price that the bank which deals in it would like to keep the balance always near zero, The bank would endeavour to find a suitable buyer wherever it purchase so as to dispose of the foreign exchange acquired and be free from exchange risk. Likewise, whenever it sells it tries to cover its position

by a corresponding purchase. But, in practice, it is not possible to march purchase and sale for each transaction. So the bank tries to match the total purchases of the day to the days total sales. This is done for each foreign currency separately. If the amount of sales and purchases of a particular foreign currency is equal, the position of the bank in that currency is said to be square. If the purchases exceed sales, then the bank is said to be in overbought or long position. If the sales exceed purchases, then the bank is said to be in oversold of short position. The banks endeavour would be to keep its position square. If it is in overbought or oversold position, it is exposing itself to exchange risk. There are two aspects of maintenance of dealing positions. One is the total of purchase or sale or commitment of the bank to purchase or sell, irrespective of the fact whether actual delivery has taken place or not. This is known as the exchange position. The other is the actual balance in the banks account with its correspondent abroad, as a result of the purchase or sale made by the bank. This is known as the cash position. Exchange Position Exchange position is the new balance of the aggregate purchases and sales made by the bank in particular currency. This is thus an overall position of the bank in a particular currency. All purchases and sales whether spot or forward are included in computing the exchange position. All transactions for, which the bank has agreed for a firm rate with the counterparty are entered into the exchange position when this commitment is made. Therefore, in the case of forward contracts, they will enter into the exchange position on the date the contract with the customer is concluded. The actual date of delivery is not considered here. All purchases add to the balance and all sales reduce the balance. The exchange position is worked out every day so as to ascertain the position of the bank in that particular currency. Based on the position arrived at, remedial measures as are needed may be taken. For example, if the bank finds that it is oversold to the extent of USD 25,000. It may arrange to buy this amount from the interbank market. Whether this purchase will be spot or forward will depend upon the cash position. If the bank has commitment of deliver foreign exchange soon, but it has no sufficient balance in the nostro account abroad, it may purchase spot. If the bank has no immediate requirement of foreign exchange, it may buy it forward. Examples of sources for the bank for purchase of foreign currency are:
Payment of DD, MT, TT, travellers cheques, etc. Purchase of bills, Purchase of other instruments like cheques. Forward purchase contracts (entered to the postion of the date of contracts). Realisation of bills sent for collection. Purchase in interbank/international markets. Issue of DD, MT, TT, travelers cheques, etc. Payments of bills drawn on customers. Forward sale contract (entered in the position on the date of contracts). Sale to interbank/international markets.

Examples of avenues of sale are:

Exchange position is also known as dealing position. Cash Position Cash position is the balance outstanding in the banks nostro account abroad. The stock of foreign currency is held by the bank in the form of balances with correspondent bank in the foreign centre concerned. All foreign exchange dealings of the bank are routed through these nostro accounts. For example, an Indian bank will have an account with Bank of America in New York. If the bank is requested to issue a demand draft in Us dollars. It will issue the draft on Bank of America, New York. On presentation at New York the banks account with Bank of America will be debited. Likewise, when the bank purchase a bill in US dollars, it will be sent for collection to Bank of America. Alternatively, the bill may be sent to another bank in the USA, with instructions to remit proceeds of the bill are credited, on realisation, to the banks account with Bank of America. The purchase of foreign exchange by the bank in India increases the balance and sale of foreign exchange reduces the balance in the banks account with its correspondent bank abroad. 7 The major risks in foreign exchange dealings Forex Risk Management The following are the major risks in foreign exchange dealings
Open Position Risk Cash Balance Risk Maturity Mismatches Risk Credit Risk Country Risk Overtrading Risk Fraud Risk, and Operational Risks

Open Position Risk The open position risk or the position risk refers to the risk of change in exchange rates affecting the overbought or oversold position in foreign currency held by a bank. Hence, this can also be called the rate risk. The risk can be avoided by keeping the position in foreign exchange square. The open position in a foreign currency becomes inevitable for the following reasons:
The dealing room may not obtain reports of all purchases of foreign currencies made by branches on the same day. The imbalance may be because the bank is not able to carry out the cover operation in the interbank market. Sometimes the imbalance is deliberate. The dealer may foresee that the foreign currency concerned may strengthen.

Cash Balance Risk Cash balance refers to actual balances maintained in the nostro accounts at the end-of each day. Balances in nostro accounts do not earn interest: while any overdraft involves payment of interest. The endeavour should, therefore, be to keep the minimum required balance in the nostro accounts. However, perfection on the count is not possible. Depending upon the requirement for

a single currency more than one nostro account may be maintained. Each of these accounts is operated by a large number of branches. Communication delays from branches to the dealer or from the foreign bank to the dealer may result in distortions. Maturity Mismatches Risk This risk arises on account of the maturity period of purchase and sale contracts in a foreign currency not coinciding or matching. The cash flows from purchases and sales mismatch thereby leaving a gap at the end of each period. Therefore, this risk is also known as liquidity risk or gap risk Mismatches in position may arise out of the following reasons:
Under forward contracts, the customers may exercise their option on any day during the month which may not match with the option under the cover contract with the market with maturity towards the month end. Non-availability of matching forward cover in the market for the volume and maturity desired. Small value of merchant contracts may not aggregative to the round sums for which cover contracts are available. In the interbank contracts, the buyer bank may pick up the contract on any day during the option period. Mismatch may deliberately created to minimise swap costs or to take advantage of changes in interest differential or the large swings in the demand for spot and near forward currencies.

Credit Risk Credit Risk is the risk of failure of the counterparty to the contract Credit risk as classified into (a) contract risk and (b) clean risk.
Contract Risk: arises when the failure of the counterparty is known to the bank before it executes its part of the contract. Here the bank also refrains from the contract. The loss to the bank is the loss arising out of exchange rate difference that may arise when the bank has to cover the gap arising from failure of the contract. Clean Risk Arises when: the bank has executed the contract, but the counterparty does not. The loss to the bank in this case is not only the exchange difference, but the entire amount already deployed. This arises, because, due to time zone differences between different centres, one currently is paid before the other is received.

Country Risk Also known as sovereign risk or transfer risk, country risk relates to the ability and willingness of a country to service its external liabilities. It refers to the possibility that the government as well other borrowers of a particular country may be unable to fulfil the obligations under foreign exchange transactions due to reasons which are beyond the usual credit risks. For example, an importer might have paid for the import, but due to moratorium imposed by the government, the amount may not be repatriated. Overtrading Risk

A bank runs the risk of overtrading if the volume of transactions indulged by it is beyond its administrative and financial capacity. In the anxiety to earn large profits, the dealer or the bank may take up large deals, which a normal prudent bank would have avoided. The deals may take speculative tendencies leading to huge losses. Viewed from another angle, other operators in the market would find that the counterparty limit for the bank is exceeded and quote further transactions at higher premium. Expenses may increase at a faster rate than the earnings. There is, therefore, a need to restrict the dealings to prudent limits. The tendency to overtrading is controlled by fixing the following limits:
A limit on the total value of all outstanding forward contracts; and A limit on the daily transaction value for all currencies together (turnover limit).

Fraud Risk Frauds may be indulged in by the dealers or by other operational staff for personal gains or to conceal a genuine mistake committed earlier. Frauds may take the form of the dealings for ones own benefit without putting them through the bank accounts. Undertaking unnecessary deals to pass on brokerage for a kick back, sharing benefits by quoting unduly better rates to some banks and customers, etc. The following procedural measures are taken to avoid frauds:
Separation of dealing form back-up and accounting functions. On-going auditing, monitoring of positions, etc., to ensure compliance with procedures. Regular follow-up of deal slips and contract confirmations. Regular reconciliation of nostro balances and prompt follow-up unreconciled items. Scrutiny of branch reports and pipe-line transactions. Maintenance of up-to records of currency position, exchange position and counterparty registers, etc.

Operational Risk These risks include inadvertent mistakes in the rates, amounts and counterparties of deals, misdirection of funds, etc. The reasons may be human errors or administrative inadequacies. The deals are done over telecommunication and mistakes may be found only when the written confirmations are received later.

8 how to reduce risks in foreign exchange risks

Each and every country around the world possesses natural resources. These resources in many ways can be very unique to the country which possesses them. In many cases, the resources a country possesses become the base for the development of the national economy. They are often raw materials and products which are exported to the world market. The countries, most invariably, will also have to depend on imports of commodities from other countries in other parts of the world. Some of the commodities may be highly essential for the sustainable growth of the national economy of the importing

country. The export and import activities require uses of foreign currencies. The values of the commodities exported and imported are determined based on the national foreign exchange management rules and foreign exchange management regulations. The countries, therefore, have to adopt a sound foreign exchange management policy compatible to and acceptable in the international trade. A foreign exchange management act will be the guide for establishing the foreign exchange management system of the country. The departments and the officials managing the foreign exchange transactions have to be well-experienced in the trade. The foreign exchange management manual becomes the essential reference for the management of foreign exchange management risk. The staff members of the departments may have to take the foreign exchange management course to be well oriented with the foreign exchange transactions.